Sample Cases 1-11 With Solutions
Sample Cases 1-11 With Solutions
Sample Cases 1-11 With Solutions
The Delta company is planning to purchase a machine known as machine X. Machine X would
cost $25,000 and would have a useful life of 10 years with zero salvage value. The expected
annual cash inflow of the machine is $10,000.
Required: Compute payback period of machine X and conclude whether or not the machine
would be purchased if the maximum desired payback period of Delta company is 3 years.
Solution:
Since the annual cash inflow is even in this project, we can simply divide the initial investment
by the annual cash inflow to compute the payback period. It is shown below:
According to payback period analysis, the purchase of machine X is desirable because the
payback period is 2.5 years which is shorter than the maximum payback period of the company.
Case 2 (Payback Period)
Sales: $75,000
Cost of ingredients: $45,000
Salaries expenses: $13,500
Maintenance expenses: $1,500
Non-cash expenses:
Depreciation expense: $5,000
Required: Should Rani Beverage Company purchase the new equipment? Use payback method
for your answer.
Solution:
Step 1: In order to compute the payback period of the equipment, we need to work out the net
annual cash inflow by deducting the total of cash outflow from the total of cash inflow
associated with the equipment.
Step 2: Now, the amount of investment required to purchase the equipment would be divided
by the amount of net annual cash inflow (computed in step 1) to find the payback period of the
equipment.
= $37,500/$15,000
= 2.5 years - YES
Case 3 (Payback Period)
The management of Health Supplement Inc. wants to reduce its labor cost by installing a new
machine. Two types of machines are available in the market – machine X and machine Y.
Machine X would cost $18,000 whereas Machine Y would cost $15,000. Both the machines can
reduce annual labor cost by $3,000.
Solution:
According to payback method, machine Y is more desirable than machine X because it has a
shorter payback period than machine X.
Case 4 (Payback Period)
An investment of $200,000 is expected to generate the following cash inflows in six years:
Year 1: $70,000
Year 2: $60,000
Year 3: $55,000
Year 4: $40,000
Year 5: $30,000
Year 6: $25,000
Solution:
(1). Because the cash inflow is uneven, the payback period formula cannot be used to compute
the payback period. We can compute the payback period by computing the cumulative net cash
flow as follows:
The payback period for this project is 3.375 years which is longer than the maximum desired
payback period of the management (3 years). The investment in this project is therefore not
desirable.
Required:
Solution:
A project requires an initial investment of $225,000 and is expected to generate the following
net cash inflows:
Year 1: $95,000
Year 2: $80,000
Year 3: $60,000
Year 4: $55,000
Required: Compute net present value of the project if the minimum desired rate of return is
12%.
Solution:
The cash inflow generated by the project is uneven. Therefore, the present value would be
computed for each year separately:
Choose the most desirable investment proposal from the following alternatives using
profitability index method:
Solution:
Because each investment proposal requires a different amount of investment, the most
desirable investment can be found using present value index. Present value index of all three
proposals is computed below:
Proposal X has the highest net present value but is not the most desirable investment. The
present value indexes show proposal Y as the most desirable investment because it promises
to generate 1.07 present value for each dollar invested, which is the highest among three
alternatives.
Case 11 (Internal Rate of Return / IRR)
A machine can reduce annual cost by $40,000. The cost of the machine is 223,000 and the
useful life is 15 years with zero residual value.
Required:
Solution:
using 15% and 18% lower and higher rates respectively:
A. Difference bet. PV at High and Low rates. = 30,400
B. Difference bet. PV at Low Rate and IRR. = 11,000
C. Difference bet. High and Low Rates = 3% or 0.03
D. Compute the IRR. = .15 + (11,000/30400) x .03 = .16 or 16%
PV of cash inflows at 16% 222, 400 or approximately at 223,000